Buy American Electric Power For A Safe 4.3% Dividend Yield

We recommend buying American Electric Power (NYSE:AEP) because of its strong last quarter EPS growth of 5.5%, attractive expected EPS growth of 4%-6%, lower payout of 46%, a decent dividend yield of 4.3%, and cheap valuations (forward P/E of 13.9x).

American Electric Power is one of the largest electric utilities in the U.S., providing services in 11 U.S. states to more than five million customers. The company is primarily involved in the generation, distribution and transmission of electricity. Almost 86% of the company's earnings are dependent on regulated services. American Electric Power operates through different divisions: Utility Operations, AEP River Operations, and Generation & Marketing. Utility Operations is the company's core business and contributes around 93% to total revenues.

American Electric has registered a strong financial performance over the years. Revenues for the company have grown to $15.1 billion for fiscal year 2011 as compared to $13.5 billion in 2009. Reported revenues for the second quarter of 2012 were $3.6 billion, in line with Q2 2011. Earnings for the quarter were 0.77 cents per share, up 5.5% YoY. Operating earnings for the quarter were $370 million, as compared to $352million in the corresponding period last year. The increase in earnings was mainly due to lower operating and maintenance expenses, resulting from lower plant outage expenses and lower storm expenses. O&M expenses for 2013 are not expected to rise. Gross profit margin increased by 0.2% for the recent second quarter. The company's western and eastern utilities experienced an improvement in gross profit margin. Margin improvement in Eastern utilities was mainly due to new rates. American Electric has maintained a healthy operating income margin over the years (in range of 18.5%-to-20.8%), despite volatile input prices. The company is expected to earn $3.06 per share in fiscal year 2012 and $3.15 per share in fiscal year 2013.

2008

2009

2010

2011

YTD 2012

Operating Income Margin

19.3%

20.5%

18.5%

18.5%

20.8%

Source: Yahoo Finance and Qineqt's calculations.

In August last month, the Public Utility Commission of Ohio (PUCO) approved AEP's Ohio plan, with slight modifications, for the period September 2012 to May 2015. The company is also expecting a favorable outcome of the Indiana rate case; hearings on the matter have been concluded, and a decision is expected by the end of 2012.

AEP has been committed to strengthening its balance sheet, and over the years its total debt to total capitalization has improved. It has a decent interest coverage ratio of 3.2x. It has an FFO interest coverage of 4.7x and an FFO to total debt of 19.9%, against the company's target of >3.6x and 15%-to-20%, respectively. The company has a strong liquidity position, and it recently extended a credit facility of $1.5 billion to June 2015, and renewed a credit facility of $1.75 billion till July 2016.

The company has had a history of strong dividends, and it currently offers an attractive dividend yield of 4.3%. It has increased its quarterly dividend from 0.39 cents in 2007 to 0.47 cents in 2012. Operating cash flow yield of 17.5% reflects the company's ability to maintain its dividends in future as well.

The company has a diverse customer base. In 2011, 29% of its energy sales were to residential customers, 28% to industrial, 24% to commercial and 19% to wholesale. Large portion of sales to industrial customers can be a risk for the company; if the economy slows down, sales to industrial customers may also fall. Going forward, another risk factor is the changes in regulations by authorities, which could negatively affect the bottom line.

In recent years, there has been more dependence on natural gas for generation of electricity due to its lower prices, the volatile price of coal and higher emission control costs associated with coal usage. American Electric has been working to take advantage of lower gas prices and improve its bottom line. The chart given above reflects the increase in the usage of natural gas in Q2 2012 as compared to Q2 2011.

The company has a high ROE as compared to its competitors. The stock is trading at a discount, based on its forward P/E of 13.9x. Its PEG of 4.2 reflects that it offers cheap growth compared to its competitors. A dividend yield of 4.3% is slightly on the lower side as compared to its competitors, primarily because of its lowest payout ratio of 46%. Using an average forward P/E of 14.7x and estimated 2013 earnings of $3.15, we get a price target of $46.5.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Utilities Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.

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